Learn How To Invest Defensively From This Hedge Fund Pro

With the Dow Jones Industrial Average and the S&P 500 hovering near all-time highs as investors shift toward a defensive stance, there are plenty of opportunities to bet against the stock market. But where to start?

Famous short seller James Chanos, president and founder of hedge fund Kynikos Associates, continues to express his deep wariness of China, along with companies tied to high-ticket items, such as artwork, and large rollups that rely on slick accounting to gussy up their balance sheets.

In interviews recently at the SkyBridge Alternatives Conference in Las Vegas, Chanos hammered home those themes, noting that a Chinese government crackdown in fraud in gambling mecca Macau could hurt gaming companies with exposure to China. Chanos didn't list specific companies with such exposure, but said that he was “worried” that U.S. companies that ran casinos in Macau were in the cross hairs of the crackdown. “We would no longer be long Macau casinos.”

Short sellers like Chanos are stock market bears. A short sale of a stock is motivated by the belief that a security's price will decline, enabling it to be bought back at a lower price to make a profit. The seller typically borrows the security, and then returns it after the stock’s share value has declined. Short selling is a high-risk strategy. (For more on this topic, see An Overview of Short Selling)

Chanos operates essentially 180 degrees differently from famed “buy and hold” investor and founder and CEO of Berkshire Hathaway Inc. (BRK-A) Warren Buffett, who buys companies he believes are fairly valued with sound fundamentals for the long run. Chanos makes bets against companies he doesn’t like, quite often after unearthing accounting flaws, and then holds onto them for the long-term. One of his most famous shorts was of bankrupt energy trader Enron Inc., which dropped from over $90 in the summer of 2000 to about $1 by the end of the next year.

China Spending Muted

The wealthy Chinese buyer has cut back on high-end purchases of ultra-expensive watches, and the Chinese government has also recently cracked down in fraud in China, Chanos noted. This month Chinese officials accused a high ranking GlaxoSmithKline plc (GSK) executive of telling his subordinates to create a large bribery network resulting in an increase in drug prices and illegal revenues of $150 million.

“And the two areas that I think are feeling it right now are luxury goods and real estate,” he said in an interview with CNBC last week. “It’s one of the reasons real estate transactions have collapsed in China this year. The next two are flight capital in terms of foreign real estate and art – Sotheby’s (BID) – and Macau. We’re getting increasingly concerned that a crackdown’s looming in Macau.”

'Silly' Art Prices

Chanos is seeing a fair amount of froth in the pricing of work by living artists, underscoring his concern for Sotheby’s. “We are short Sotheby’s,” he said. “We think at this point in the contemporary art cycle we are seeing a lot of silliness.”

Contemporary art is what’s moving at the auction block right now, he said, citing examples of high-priced auctions for living artists. That concerns Chanos. “And usually when the art market gets silly, it’s usually time to be out of Sotheby’s. What really concerns us is that a lot of the action is not in artists who are dead, to be blunt. It’s in young artists who are still producing a lot of art, and at these prices will produce even more.”

Wary of Rollups

Chanos is also calling into question the business model of Valeant Pharmaceuticals International Inc. (VRX), which has been involved in dozens of mergers since it was created in 2010 by combining Valeant and Biovail. Valeant recently made a hostile bid for Allergan Inc. (AGN), which makes Botox.

In an example of merger arbitrage, He has shorted Valeant and has a long position for Allergan.

"We're short because it's a rollup, and rollups are a unique set of problems," he said. "Rollups are generally accounting-driven, and we certainly think that's the case in Valeant.”

Chanos’ belief is that the company is “playing some very aggressive accounting games" when they buy companies and write down the assets. He added that the Valeant executives are selling shares. “Finally, the only people who are more negative about Valeant than maybe me are Valeant insiders."

Add to that the fact that half a dozen executives have departed Valeant in the past year and a half. "I mean, there seems to be not a lot of confidence from inside the Valeant executive suite here. And that's putting aside the deal dynamics, which is a whole separate story."

Mining Declines

As with China, Chanos is continuing to short Caterpillar Inc. (CAT), a company with diverse businesses that is trading above multiples. The value of commodities like iron and coal – which Caterpillar's products help extract – continue to decline, he said, adding to his questions about the company's near-term prospects.

“I think people are generally of a belief that this is a North American construction play. It’s 15% of their business,” he said. “Maybe it’s an oil and gas play. Caterpillar is a very diverse company. A big part of their profits are in mining, which continues to decline. The stock is trading above a market multiple for a cyclical company, where even the management has said they think trough earnings could be $3.50. We don’t get it.”

The Bottom Line

As stocks see strong headwinds, investors can take a few tips from a successful short-seller. One big factor will be a slowdown in economic activity in China, from sagging commodities prices to flagging sales of luxury goods and art. Investors should also consider the government's recent steps to stem fraud on the mainland and in the gambling mecca of Macau. When it comes to China-related investments, tread carefully.